Knowledge@Wharton Finance and Investment Research Article

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The stock market's June swoon has carried into July, with key indicators pointing to a bear market weighed down by rising oil prices, the credit crisis and more bad news from Detroit, as the Big Three auto manufacturers reported substantial losses. Meanwhile, the G-8 gathered in Japan to discuss global warming and the economy, but didn't include the two largest emerging economies -- China and India -- in the talks. Knowledge@Wharton spoke to Wharton finance professor Jeremy Siegel about these developments and others.

An edited transcript of the conversation follows.

Knowledge@Wharton: The Dow Jones Industrials have fallen about 15% on the year and are still firmly in bear market territory, down by about 21% from their high in October. The S&P is near bear market status, down 20% from its record close in October - and the S&P is down about 15% for the year to date. These are "gut check" times for those of us who invest for the long term. What's it going to take to trigger a recovery on the market?

Siegel: The market has been hit by a one-two punch. The first punch was the credit crunch that started at the end of last year, because of the housing bubble that burst. The second punch, which I think is now a stronger punch are the energy prices, the gasoline prices and the oil prices above $140.  And, I often said that I thought that the economy could handle either one; but both together, that is really tough.

Actually, I think people are saying "Why is it only down 20%" because we have seen bear markets down 50%. The truth of the matter is that there are a number of good things out there that I think are keeping the decline in the moderate territory. What do we need to get it moving back up again? And, that is lower energy prices. I think that that is the key. If we get oil back down into the $100 region, gasoline stabilized and back down to even $3.50 a gallon, which I know is still high, but I think that that will be an important part of the recovery for the markets.

Knowledge@Wharton: I know that the auto industry would love to see that happen because they had an awful June, especially the "Big Three" in the US. -- Ford, GM and Chrysler. They seemed to have gotten themselves caught in the same trap that they did in the 1970s and 1980s; building the wrong vehicles for the wrong time. Can they pull out of this again?

Siegel: And they are paying the price, as they should for that. I mean no one predicted that oil would go this high, but everyone knew that it certainly wasn't going to go lower. The hybrids and alternative fuels -- they have to put all of their resources there. And, of course, the big problem is that they were weak even before this, with the pensions which is working out with the UAW. So, they've got that double whammy on them, hopefully to bring some leverage on their current situation, to resolve the health care and some of their pension fund costs which is really another big problem that they have.

Knowledge@Wharton: And, their competitors don't have to carry those kinds of costs.

Siegel: Absolutely and that's a major factor.

Knowledge@Wharton: The two government sponsored mortgage companies, Fannie Mae and Freddie Mac, fell pretty dramatically on Wall Street on Monday, July 7^th, signaling a lack of confidence among investors, we're told. If the companies fall short of capital, they'd have a harder time securing mortgages. That would raise some home buyers borrowing costs and likely drive down home prices further. What does that say about the prognosis for the crisis?

Siegel: First of all, the government is not going to let Freddie Mac and Fannie Mae fail. I mean, given the way the Fed and others have been extending credit, these are very essential institutions. So, my feeling is that a top priority for the government and the Fed is to make sure that conformable mortgages -- those that are under the limits and conform to that -- will still be flowing at a normal rate. Jumbo mortgages have a surcharge and they will continue to have a surcharge, compared to where they were a couple of years ago.

But, no matter what happens, [you know, the fears on Wall Street] I know that there is a back up there -- to make sure that conformable mortgages will still be okay. This is because we all realize that if you cut off that conduit, you'd really spiral the economy into a recession. And, there's far more public support to making sure that those mortgages are available than giving money to the investment banks, which the Fed did in March.

Knowledge@Wharton: And those problems on the credit front in the United States are of course being felt globally in some of the other markets. How do you see this playing out in economies outside of the US?

Siegel: You know, I was reading an interesting analysis; JP Morgan sort of said that Europe is probably about 6 months behind in its cycle of slow down to the US; and, the emerging markets, a year behind, which is interesting. No one is going to be immune from the energy crunch. It is affecting everyone. And of course, for some of the poorer countries, the food crunch is as equally important; not to the developed countries, but to the developing countries.

But, I think that everyone is going to be affected by the energy crunch. And, I really think that again, if I were to say "What is bedeviling the market right now, worldwide?" I would say that the energy question is more important now than the credit question.

Knowledge@Wharton: The G8 gathering in Japan is underway, as we speak. Do you think that they will come up with any meaningful proposals, or will their results be long on rhetoric and short on substance?

Siegel: That seems to be the case all the time. There is a lot of rhetoric. You know, they talk about exchange rates; the truth of the matter is we economists know that it's really the Central Banks. Even though they say that "We're going to give it to the Treasury." It's the Central Banks that make the important decisions on monetary policy and that really affects the exchange rates between the countries.

You know, everyone knows that George Bush is a "lame duck" president and that starting an initiative now, when we know that we are going to have a new president next January, is going to be pretty hard to do. So, there will be rhetoric... that we're all working together to solve the problems of pollution, global warming, energy crisis and food -- but not much on action.

Knowledge@Wharton: China and India are not participating in that. Is that a sin of omission?

Siegel: Absolutely, I mean when everyone talks about what are the sources of the energy crisis, we always talk about the insatiable appetite from China and India -- and now we leave them out of G8, in terms of talking about what they could have done. I mean, clearly I think you have to expand it to these other two countries, to really get a global look at all of the factors affecting the world economy.

Knowledge@Wharton: San Francisco's Federal Reserve Bank president, Janet Yellon,             said yesterday that the Fed can't just be hopeful that inflation will come down, but that it must be prepared to make hard choices as needed, according to a report in The New York Times. Is the Fed indeed prepared to make hard choices and what should those choices be?

Siegel: Well, you know, for the last year the Fed has been saying "We expect inflation to moderate as the economy slows." And the truth of the matter is we haven't seen inflation moderate and it's beginning to be [kind of] thrown back in their face with "You keep talking about this and it's not happening." I had stated in an earlier podcast that I didn't like them going down all the way to 2% from 2.25%. It was more of the signal, than the importance of a quarter of a point. But, clearly they're not going any lower.

My feeling is that if we can crack oil prices and this is the second day now, as I'm talking, that we've had some big declines that they won't need to raise this year. If oil goes back down into the low $100 region, my feeling is that they are going to stay at the 2% through the remainder of the period. The dollar has been holding up fairly well, as the other world economies soften a little bit, they don't feel that they'll have to raise it up.

If oil continues upward and we see those commodity prices continue to move upward, I think that they are going to have to join the ECB and perhaps others in saying "We've got to stand against this commodity inflation." It is a painful choice and she is right. But, if commodity prices [again] start rising, they would need to do it. If commodity prices break, if we did see the peak a couple days ago, my feeling is that they will hold on the rate for the rest of the year.

Knowledge@Wharton: We talked a little bit about rhetoric at the G8 meeting, which brings us of course to the presidential election here in the United States. Senator John McCain, the presumptive Republican nominee said on July 7^th that his administration would balance the US Federal budget deficit by the end of his first term and that would be 2013.

Senator Barack Obama, the presumptive Democratic nominee once made a similar pledge, but now says the goal is more likely to be 8 years. Both are proposing various tax cuts and rebates, but have been vague about how they would reduce spending. Can you give us a reality check on the candidates' fiscal policies and maybe remind us about the pros and cons of running a deficit?

Siegel: Well, first of all, let me say that the reality check is that I don't think it's going to close in 4 years or 8 years. I think that we will probably be running a deficit for decades. Now, that isn't bad as long as it stays in a certain proportion to the GDP, we don't actually have to balance the budget. I think that there are a couple of things on the table that are important.

Now, do we need another fiscal stimulus package? It has helped. The GDP is going to come out in a few weeks and I expect the second quarter to be up between 2% and 3%. If you remember, it was 1% the previous two quarters. But what happens is if oil prices don't go down, the third and fourth quarter could be much weaker, particularly the fourth quarter which we might want to think about another fiscal stimulus package then. There is one thing that...this is under Bush's watch.

You know, the truth of the matter is we know that taxes are going to go up. Tax rates are going to go up whether McCain wins or Obama wins, because we are going to have a Democratically controlled Congress and the Bush tax cuts are going to expire. So that's going to be a reality.

But, one thing that is very important and that is the most important thing we can do to close the deficit is not to start raising taxes, especially under a weak economy, but to stimulate economic growth. I mean Clinton balanced the budget not really through new taxes, but by an incredible growth surge that we had through the 1990s and that's when we balanced it.

If we can get back on the growth path, get those energy prices down and put into place policies that are going to get us on the growth path that will do more than tax policies in terms of closing the deficit. This is just something that we all have to keep in mind when we talk about deficits into the future.

Knowledge@Wharton: Well, thanks very much.

Siegel: Thanks for having me.

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